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Course: Personal finance>Unit 3

Lesson 5: Debt repayment

High rate vs snowball method

If you have multiple forms of debt, how should you prioritize repayment? This video analyzes two popular strategies for debt repayment to determine which will cost less money over time.

Want to join the conversation?

• I don't understand why the High Rate Method is the most mathematically optimal. A \$500 debt with 15% APR will incur less interest than \$2000 of debt with 10% APR. In the former, you would incur \$75 of interest a year; in the latter, you would incur \$200 of interest a year even though it has a smaller APR. So wouldn't the optimal way to be pay off the debt balance with the highest interest payment overall after accounting for APR * debt?
• I think it varies depending on how long you have the loan. So you would be right, and it really depends on the situation.
• Does it still make sense to be saving during the time you have debt?
• It's more economically beneficial to pay off the debts first and then save, but you don't know when you might need some emergency money.

If you only pay off the debts, you might not have money for emergencies when you need them.
If you only save, the debts would either grow (if you don't pay the interest rates) or remain the same.

So it's better to split the money into both savings and paying off debts.
(1 vote)
• Did you imply the Snowball works this way? With Snowball, after the credit card is paid, you then have \$120 to put toward Loan A each month. After Loan A is paid, you have \$195 to put toward Loan B each month. After the first 3 debts are paid, you will be paying \$300 a month toward that final Retail Card debt. Psychologically you see not only the individual debts being paid off faster, but feel the difference of making larger and larger snowball payments toward the next debt. Eventually you have that extra \$300 of your own money to spend, save, invest as you want every month for as long as you stay debt free!
• That is precisely how it works. You got it.
• If he's only paying \$20 (by the credit card debt, for example), its still goin up 15% [(500-20)x1.15=552]. The same is by all other debts. So how does he ever pay up his debt, it keeps growing?
• The payments in the example are monthly payments, while the interest rate given is annual. So for the credit card in the example, the annual interest on a \$500 balance is 0.15 * \$500 = \$75, which is less than 12 months of minimum payments, which would be \$20 * 12 = \$240. That being said, the retail card in the example is strange in that the annual interest on a \$4000 balance is \$1200, while the minimum payments only total \$360, so if you made just the minimum payment, your retail card debt would be ballooning out of control.
• how do I calculate how long it will take to pay off my debts
• Also on Microsoft Word, Publisher, and Powerpoint documents.
• how do you solve APR with?
• Assuming I started all these debts on the same day, (using the high rate method) what would the equation be for me to pay all the debts, plus the \$3,904 interest in total in 47 months? I'm confused about the APR, as the APR starts when you're unable to pay off the balance on time and grace periods aren't shown in the video
• I just looked up for a formula, it's more complicated than what we've seen so far:
t = log{PMT/[PMT−(r*P)]} / log(1+r)
where:
PMT - the monthly payment amount.
r - the monthly interest rate (APR divided by 12).
P - the principal amount (initial debt).
t - the amount of time it takes to pay the debt

For the Retail Card it's ~60 months, for Credit Card it's ~31 months, for Loan A it's ~31 months and for Loan B it's 52 months.

On Month 31, we pay Credit Card and Loan A debts and we get some extra money too, as well as not needing to pay the Monthly Minimum Payment for them, which frees up \$95, so we can now give \$95 monthly towards the Retail Card debt, on top of the \$130 we are already paying. This is a x1.7 rate increase, but given that the Interest we pay lowers as we pay more of the loan, this might reduce the time amount by an even bigger factor, let's say x2-x2.5.

So instead of ~60 months we might pay 40-45 months and get rid of the Retail Card debt, then we only have the Loan B left to pay, which normally took 52 months to pay, but because we paid of Retail Card by month 40-45 and we now have \$300 going towards reducing it instead of the previous \$75, this might speed it up such that we manage to pay off this last debt by month 47 as said in the video.
(1 vote)
• What's a retail card?
• You posted this question 10 hours ago. Upon seeing it a few minutes ago, I used a popular search engine and typed "retail card" into the search box. (If your parents allow you to use search engines, you could do this too.) Now, after you've waited at least ten hours, here is what I learned for you:

"In essence, a store credit card is a credit card offered by a specific retailer that you can only use with that retailer. For example, if you have a Target REDcard, you can only use the card to make purchases in a Target store or at Target.com."

As good as this course is for you in terms of financial literacy, I think you might also benefit from a course in "search skills". Ask your parents for permission to take one. Then, when you have a simple question like this, you won't have to wait.